British Gridlock Isn’t Bearish

Britain's election is 23 days away, and pundits near-universally agree it will spell disaster for UK markets. One analyst warns of a "Lehman moment" for the pound if no one wins.^[i]Another says election uncertainty is shrinking foreign demand for UK bonds, and fractured politics could cost the UK billions in foreign investment. Worst of all, several warn a hung Parliament could raise the risk of a second contest this year-and trigger a repeat of 1974, when UK stocks plunged nearly 48% between elections in February and October.^[ii] Please allow us to put that one to bed: Today is nothing like the early 1970s. Electoral jitters could drive volatility in the vote's run-up or aftermath, but this shouldn't cause a bear market in Britain or the world.

There is nothing inherently bearish about a hung Parliament (one in which no party has an absolute majority, for yanks), whether it yields a functioning coalition or a shaky minority government. Britain's history with hung Parliaments is very limited, but bull markets have coincided with two of three. Britain has had a coalition since May 2010, and UK stocks have done fine-since the 5/6/2010 election, they're up 60% in sterling and 56% in dollars.^[iii] UK stocks also rose while a minority government presided from March 1977 - March 1979-a period that included the severe labor unrest known as the Winter of Discontent. Hung parliaments mean gridlock, which-contrary to widespread belief-doesn't create uncertainty. It actually reduces the risk of radical new laws, a major source of uncertainty. Considering most fret radical change from both major parties (price controls and England-to-Scotland redistribution from Labour, EU exit from the Conservatives), gridlock should bring relief. Britain is one of the world's most competitive economies, and its growth rate is among the developed world's highest. If Parliament has a low likelihood of messing that up, as it would with a minority or coalition government, investors have little or no reason to shun UK stocks.

"Yah, but 1974." That's when an election on February 28 ousted Edward Heath's Conservative government as Labour won the most seats-but fell 33 shy of a majority. Labour led a minority government for seven months, before Prime Minister Harold Wilson called a snap election for October 10, which yielded Labour a three-seat majority. In between the contests, UK stocks plunged.

Yet it is revisionist history to blame this freefall on the minority government's presence. For one, a global bear market ran from January 1973 through October 1974.^[iv] That had very little to do with British electoral theatrics and much, much more to do with price controls and erratic monetary policy in the US and Britain, as well as an oil crisis that struck in the middle. UK stocks peaked five months before the US and bottomed two months later, but you can't pin that on electoral uncertainty alone. Or gridlock, considering Wilson passed some big measures despite his minority.

While Richard Nixon's price and interest rate controls have the most infamy in America, Britain's were plenty harmful, too. The UK had dealt with some form of price controls or rationing since World War II, but Heath's government initially sought to change that, abolishing the National Board for Incomes and Prices shortly after taking power in mid-1970. Heath believed competition would better tame prices, reducing inflation-then running above 7% annually. However, competition takes time to work, and the earlier price controls had fostered supply shortages-so inflation soared after price caps were lifted, topping 10% by June 1971.

Inflation started easing that September, but not for long. That same month, the BoE decided its primary means of controlling money supply-lending caps-was no good, and launched a short-lived experiment with monetary reform. Under the new system, banks were allowed to lend freely, and the BoE used reserve requirements and open market operations to manage money supply instead. They also cut rates, complementing Heath and Chancellor Anthony Barber's "dash for growth" fiscal policy. Lending and broad money supply soared, and by August 1972 inflation was rising again. In a misguided effort to tame prices without turning the growth dash to a crash, Heath and the BoE kept the floodgates open but reinstated broad wage and price controls that November.^[v] Inflation soared, peaking at 26.9% y/y in August 1975. And the dash crashed anyway-recession began in Q3 1973.

High inflation had a destructive secondary effect. Britain's miners had emerged from a 1972 strike among the world's highest-paid. But with wages capped as inflation rose in 1973, real wages suffered, and labor unrest resurged, threatening the supply of coal for power generation. Anticipating a strike that December, Heath mandated that no business could use electricity for more than three consecutive days per week. That took effect December 31 (along with regular rolling blackouts), the miners struck from February 9 through March 6, and new Prime Minister Wilson reinstated the five-day workweek on March 8, while keeping other energy restrictions in place. With businesses shuttered or working by candlelight, GDP fell -2.7% q/q (-10.9% annualized) in Q1 1974 alone.

Wilson's minority government ended the strike and presided over a recovery that began in Q2 1974, but other than that, fundamentals weren't much improved. Price controls persisted. Inflation still soared. Legislation like July 1974's Trade Union and Labour Relations Act, which repealed most of 1971's labor market reforms, radically changed industry's landscape. GDP resumed falling in Q4 1974. So UK stocks kept tumbling, right on past Election #2, ultimately bottoming in December 1974. Peak to trough, they lost about 64%-far worse than the S&P 500's 48% peak-to-trough decline from 1/11/1973 - 10/3/1974.^[vi] UK stocks had it worse not because of seven months of alleged political uncertainty in 1974, but because life there was just harder.

Coincidence isn't causality, and just because one minority UK government coincided with seven months of a nearly 28-month British bear market doesn't mean a hung Parliament would see a bear today. Fundamentals now are worlds away from then. The world economy is healthier. Inflation is benign. Markets are freer. Price controls are nonexistent in the developed world. The BoE, Fed and other major central banks are politically independent. Markets might wobble surrounding the election, as UK stocks did in the weeks before and after 2010's vote, but longer term, gridlock's benefits and strong economic drivers should win out. Especially because expectations for a hung parliament are so low. As markets price in all the angst, gridlock gains room to be a big bullish surprise.